Volatility, Intermediaries, and Exchange Rates

53 Pages Posted: 20 Nov 2016 Last revised: 23 Jul 2021

See all articles by Xiang Fang

Xiang Fang

The University of Hong Kong

Yang Liu

The University of Hong Kong - Faculty of Business and Economics

Date Written: February 24, 2021

Abstract

We propose and estimate a quantitative model of exchange rates in which participants in the foreign exchange market are intermediaries subject to value-at-risk (VaR) constraints. Higher volatility translates into tighter VaR constraints, and intermediaries require higher returns
to hold foreign assets. Therefore, the foreign currency is expected to appreciate. The model quantitatively resolves the Backus-Smith puzzle, the forward premium puzzle, and the exchange rate volatility puzzle and explains deviations from the covered interest rate parity. Moreover,
the model implies both contemporaneous and predictive relations between proxies of leverage constraint tightness and exchange rates. These implications are supported in the data.

Keywords: Volatility, Financial Intermediaries, Exchange Rates, Currency Return, Value-at- Risk

JEL Classification: G15, G20, F31

Suggested Citation

Fang, Xiang and Liu, Yang, Volatility, Intermediaries, and Exchange Rates (February 24, 2021). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2872904 or http://dx.doi.org/10.2139/ssrn.2872904

Xiang Fang

The University of Hong Kong ( email )

Pokfulam Road
Hong Kong, Pokfulam HK
China

Yang Liu (Contact Author)

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

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